What is Gross Domestic Product (GDP) ?

Gross domestic product (GDP), this is a term which is familiar to pretty much anybody who has ever read any newspaper. This number is considered by many to be the most important indicator of the state of the economy. However, how little clarity we have on the subject is remarkable. The average public is not completely ignorant about what GDP is. They do have some idea about the GDP number and its importance. The issue is that they harbor a lot of wrong notions about this subject. If many economists are to be believed, these wrong notions are extremely dangerous and may have in fact played a huge part in the recent economic crisis that halted the growth of the global economy.

All these arguments, the pros and cons make any sense only after we have a clear idea about what GDP is. This article is meant to clarify the purpose of GDP number:

Absence of a Barometer for the economy

In older days, statesmen found that gauging the health of the economy at any given point was a very difficult task. Any policies meant for the improvement of the economy could only be implemented if the present state of the economy was known. However, economy is a very complex system. There are numerous factors like employment levels, inflation levels, debt levels etc that need to be considered before any conclusion about the present state of the economy can be arrived at. Therefore, the answer to the question “How is the economy doing?” was pretty complex.

The statesmen wanted a simpler answer, a simple barometer that would tell them the current state of the economy. They could then use this information to formulate policies. GDP was the end result of this quest. The main reason of GDP is to communicate to the general public information regarding the health of the economy.

GDP-Composite Metric

The GDP number, therefore, in many ways is a composite metric. The purpose of GDP is to assimilate all the information is all metrics like inflation numbers, debt numbers etc and present it to the general public and the policymakers in the form of actionable information.

GDP-Quantifiable Fact

Secondly, GDP is meant to free economists from the realm of opinions. Prior to GDP, any conclusion regarding the state of the economy was purely based on opinions and had very less backing in the form of quantitative evidence. With GDP, this has changed and the average person can state with precision the direction as well as the magnitude in which economic movement has occurred.

GDP-Common Sense and Intuitive

The GDP number is considered so important because of its perceived simplicity. While many economic indicators are complex to decipher, the GDP number is extremely simple. If the number goes up, it means good news and if the number goes down it means bad news, that’s it! The magnitude of this good or bad news is also stated in terms of percentages. Hence, the number is exceedingly simple to interpret.

Definition:

The textbook definition of GDP is

“Gross domestic product (GDP) includes the monetary value of all goods and services which are produced within the geographical boundaries of a given country in a given time frame”

Notice the defining criteria. Production should have happened within the country’s boundaries and within a given time period.

The Logic behind the GPD Idea

The logic behind the GDP idea is simple as well. Economists have discovered through empirical analysis that if the production within a country increases, then so does the employment and the inflation comes under control and so on.

All major measures which correlate to the good health of the economy are also correlated with the Gross domestic product (GDP). Hence, when the news that GDP has grown spreads into the economy, the common population assumes that the economy is in a very healthy state. As we shall see in the rest of this module, this is a false assumption.

It is possible for the GDP to grow when all the underlying metrics are in fact declining. In this case, the link between GDP and the underlying economic growth is broken and the GDP number becomes misleading at least and dangerous at worst!